This is a translated and edited version of a Chinese article published earlier on fundsupermart.com.hk on 25 Jul 19.
Highlights:
- Mainland developers that have insufficient cash flow or higher leverage will be more affected by the tighter measures of Chinese government to restrict developers’ access to financing.
- Fundamentals of the Chinese property market remain sound. As the government’s policy stance is driven by its commitment to ensure stability, it is likely to ease curbs after the property market cools off sufficiently.
- Widening spreads present opportunities for investors; high yield Chinese developer bonds are attractive at their current valuations. However, prudent credit selection in identifying issuers with better credit quality and prospects is key.
In the first half of 2019, under the multi-pronged policy of the Chinese government, many changes have taken place in the real estate market. Amongst the regulatory changes, more restrictive measures on financing channels have had the biggest impact on the property developers.
In this article, we will discuss the latest policy implemented by the Chinese government that restricts developers’ access to funding, as well as challenges and opportunities in the Chinese real estate credit sector.
China tightens financing rules for property developers
Policies implemented this year to restrict various financing channels
“High turnover, high leverage” is the most common business model among mainland property firms. As can be seen from Figure 1, the industry’s average net debt-to-equity ratio is more than 100%, which is much higher than other sectors.
Figure 1: Average net gearing ratio of mainland real estate credits (offered on the FSM HK platform)
Bank loans, trust financing, and onshore and offshore bond issuances (including asset-backed securities) are among the main financing methods for property developers. However, the recent clampdown on financing channels by the central government has imposed restrictions on all of the methods mentioned above.
For bank loans, the central government has for some time now restricted property developers from using bank loans to acquire lands. In May, the China Banking and Insurance Regulatory Commission (“CBIRC”) announced that it will crack down on violations in property loans, including lending to unqualified development projects, which further tightened developers’ access to bank loans.
After growing rapidly in the first half of the year and becoming the primary funding means for land acquisitions, trust financing of real estate projects has started to face increasing scrutiny. Since June, the CBIRC has launched a series of investigations and warnings on trust companies, leading to a sharp decline in the number of newly established trust vehicles.
In July, regulators announced new rules requiring project companies seeking trust financing to have a direct controlling shareholder with at least a second-grade qualification for real estate development. The project companies are no longer allowed to obtain trust loans by riding on the qualification of their ultimate parent—the holding company that sits two levels above or more in the corporate structure. Due to the demanding requirements to apply for a second-grade qualification in real estate development, and the fact that developers are used to setting up a new project company every time they acquire a piece of land, the new measures will undoubtedly affect large developers with complex corporate structure.
Bond financing was not spared. According to market reports in March, China’s National Development and Reform Commission (NDRC) tightened the issuance quotas for first-time issuers of US-denominated bonds. Furthermore, some developers were reportedly restricted from issuing onshore bonds and asset-backed securities temporarily.
In July, the NDRC further demanded that proceeds from offshore bonds sold by real estate firms should only be used to refinance existing debt maturing in the upcoming year. The developers will also need to disclose more details on the use of issuance proceeds, which increases the difficulty for developers to meet regulatory requirements and sell large amounts of bonds, and should lead to a significant slowdown in issuance volume.
Higher issuance of USD debt accompanied sliding funding cost at the start of 2019
Nevertheless, we have seen much higher dollar bond issuance volume from mainland developers this year as compared to 2018. Chinese real estate firms issued more than USD10 billion in both January and February, the highest single-month volume in two years.
One of the reasons behind the flurry of USD debt issuance was the declining average coupon rate on new dollar bonds of mainland developers, over the first three months of 2019 (see Figure 2). The lower funding cost led to higher offshore issuance appetite for developers that rely heavily on borrowing to maintain their cash flows. However, the credit environment tightened after that and coupon rates jumped in April, before gradually falling off again.
Figure 2: USD bond issuance by mainland developers—monthly volume and trend in coupon rates
Outlook on the Chinese property sector amid tight funding conditions
Sound fundamentals provide upside potential for home prices
Regulations on the real estate sector have gradually evolved from imposing basic property buying curbs to strict financing controls, which will indubitably reduce the overall sector liquidity. However, we should note that the purpose of regulatory actions is not to bring down the housing market, but to suppress excessive exuberance and maintain market stability.
It is our opinion that the strong housing demand and rapidly rising home prices in China have made it necessary for the Chinese government to strengthen regulations on the real estate sector. Given healthy sector fundamentals, we think there is still room for property prices to grow, although prices are unlikely to see explosive growth as in the past.
The impact of funding curbs is still manageable
Mainland developers are still allowed to issue new debt for refinancing purpose, and there are fewer restrictions on the tenor of new bond issues. In addition, the falling interest rate environment benefits developers with lower borrowing cost. Consequently, there is still room for maneuver for most developers, which also have the option of raising funds through issuing commercial papers with less restrictions.
As for trust loan financing, which is an increasingly favored source of funding, the CBIRC said on 11 July that it never called a halt on trust companies’ real estate financing businesses, easing negative sentiment in the market. As the residential sector’s performance has been declining in recent months, the government has already achieved its goal of cooling down the housing market to a certain extent. Hence, there is a possibility that the government may ease housing policies.
Our views on Chinese real estate credits
Valuations are attractive: spreads between high-yield and investment-grade credits have widened
When assessing the valuation of a credit sector, we often look at trends in credit spreads, which indicate the return difference between credit investments and risk-free rates.
Given widespread expectations of more accommodative monetary policies, benchmark rates have been falling since the end of 2018. Although overall yields on Chinese real estate credits have also fallen considerably, but we notice that relative price movements between high-yield and investment-grade developer credits (against US Treasuries) have diverged since April (see Figure 3), with investment-grade Chinese developer credits recording much stronger relative price strength.
Figure 3: Relative movements of iBoxx bond price indices (vs UST) since July 2016
This implies that investment-grade Chinese developer credits have been more favored by the market. Slowing sales growth outlook and increasing policy uncertainties have caused investors to take a more cautious stance toward high-yield bonds.
In addition, widening spreads between high-yield and investment-grade credits suggest that the real estate sector is not facing structural issues that threaten industry fundamentals. Instead, it is just high-yield bonds that are becoming more undervalued.
As of mid-July, high-yield bond spreads have returned to a higher level, close to where they were in August last year. We think that Chinese high-yield real estate names look attractive, and are well suited for investors looking for higher returns.
Credit selection is key
However, asset prices tend to reflect rational investor behavior, and issuers with lower credit quality (e.g. high leverage or low market capitalization) are indeed more vulnerable to market volatility and policy uncertainty, which in turn will affect their creditworthiness.
Therefore, investors will need to analyze individual company’s credit profile, financial performance, vulnerability to policy curbs, and management. We expect increasing pressure on developers to strike a balance between land acquisition and managing cash flow needs amid the tighter credit environment. In this context, we prefer large developers due to their competitive advantages in size and branding.
After winnowing down to issuers with better credit quality and business prospects, we would compare further on their credit ratings, bond maturities, and bond terms and conditions to identify those that offer superior risk-adjusted returns.
Conclusion
A more detailed discussion on the macro environment of China’s property sector is outside the scope of this article. Nonetheless, we believe that the fundamentals of the property market are overall sound. Restrictions on developers’ financing channels reflect the resolve of the Chinese government in driving down leverage in the real estate sector.
Overall, we think the industry risk is still manageable. As compared to the end of last year, borrowing costs have decreased slightly, making it more conducive for developers to issue debt. In addition, as the government’s policy stance is driven by its commitment to ensure stability, it is likely to ease curbs after the property market cools off sufficiently.
In term of bond investments, it is our view that high-yield Chinese developer bonds are attractive at their current valuations. Widening spreads have brought opportunities for investors, but prudent credit selection in identifying issuers with better credit quality and prospects remains key.
Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the securities mentioned.
